Contract or Toll? Navigating VAT Risks in Manufacturing Arrangements
As global supply chains become increasingly complex, many businesses rely on third party manufacturers to improve efficiency, reduce production costs, and scale operations quickly. However, the VAT implications of contract and toll manufacturing arrangements are frequently misunderstood, particularly in cross border structures where incorrect classifications can trigger unexpected VAT registrations, compliance burdens, and significant audit exposure.
What Are Contract and Toll Manufacturing Arrangements?
Toll manufacturing generally refers to an arrangement whereby a principal company provides raw materials or semi-finished goods to a third-party manufacturer for processing into finished products.
Throughout the process, ownership of the goods remains with the principal company, while the manufacturer performs services on those goods.
By contrast, under a contract manufacturing arrangement, the manufacturer will often procure the materials itself and supply finished goods to the principal company.
Although these arrangements may appear commercially similar, the VAT consequences can differ significantly depending on whether the manufacturer is regarded as supplying goods or providing services.
Why the VAT classification matters
The VAT treatment of a manufacturing arrangement depends on whether it constitutes:
- a supply of goods under Article 14 of the EU VAT Directive, or
- a supply of services, with the place of supply for B2B services generally determined under Article 44.
The classification of the arrangement drives the place of supply, which in turn determines VAT registration obligations, reporting requirements and compliance exposure.
- Contract Manufacturing
In a contract manufacturing model, the manufacturer is generally making a supply of goods. The place of supply is typically where the goods are located at the time of dispatch or transport.
This may require the principal company to register for VAT in the manufacturer’s jurisdiction, particularly where:
- title of the goods transfers locally,
- goods are stored before onward sale,
- or inventory is held in the manufacturer’s country.
- Toll Manufacturing
In a toll manufacturing arrangement, the manufacturer is generally supplying a processing service. Under the standard B2B place of supply rules, VAT is typically accounted for by the principal under the reverse charge mechanism in the jurisdiction where the principal is established or has a Fixed Establishment.
However, this does not eliminate all VAT obligations for the principal. Businesses may still need to manage:
- intra-EU dispatch and acquisition reporting,
- Intrastat obligations,
- and SAF-T or equivalent digital reporting requirements in certain jurisdictions.
Even when VAT is correctly applied, failures in these reporting obligations can lead to penalties.
Economic reality
As the EU VAT Directive does not provide formal definitions for either contract or toll manufacturing, VAT authorities and courts rely heavily on the economic reality of the arrangement.
In practice, authorities typically examine:
- who owns the raw materials,
- who contributes significant value,
- who bears commercial and production risk,
- the level of operational control exercised by the parties,
- and whether the manufacturing process fundamentally transforms the product.
While ownership of raw materials remains an important indicator, it is not determinative on its own. VAT authorities increasingly focus on the manufacturer’s contribution to the finished product and the overall commercial substance of the arrangement.
Where the economic reality differs from the contractual description, reclassification is common and can become costly from a VAT perspective.
The position of the Court of Justice of the European Union (“CJEU”) is clear: VAT follows economic reality.
The nature of a supply is determined by what is happening in practice, the functions performed, the risks borne, and the value contributed, rather than by how the parties choose to describe the arrangement in their contract.
How Different Countries Approach Manufacturing Arrangements
While the CJEU provides overarching principles, individual Member States often apply their own administrative approaches when assessing whether a manufacturing arrangement constitutes a supply of goods or a supply of services.
France remains one of the clearest examples of a structured administrative framework for distinguishing toll manufacturing (façonnage) from a supply of goods.
France: The Four-Part Façonnage Test
French VAT authorities generally examine whether:
- The raw materials and semi-finished goods remain the property of the principal throughout the manufacturing process, with the manufacturer never taking title of the materials.
- The manufacturer performs only processing or assembly services and does not supply the essential materials or core components forming part of the finished product.
- Any additional materials supplied by the manufacturer are merely ancillary or incidental to the primary processing activity.
- The finished goods are returned to the principal or delivered to a third party on the principal’s instructions following completion of the processing work.
Where one or more of these conditions are not satisfied, the French VAT authority may seek to reclassify the arrangement as a supply of goods rather than a supply of service.
While France applies one of the more clearly articulated administrative frameworks, many other jurisdictions adopt a broader substance over form approach based on the overall economic reality of the arrangement.
Fixed Establishment risks: The hidden exposure
One of the most significant risks in manufacturing arrangements, particularly toll manufacturing, is the potential creation of a Fixed Establishment (FE).
VAT Authorities are increasingly scrutinising whether principals involved in manufacturing operations have sufficient human and technical resources “at their disposal” within another jurisdiction.
Risk levels generally increase where the principal:
- places equipment at the manufacturer’s premises,
- directs production planning,
- has personnel regularly present onsite,
- or exercises detailed operational oversight of the manufacturing process.
If a Fixed Establishment is deemed to exist, the principal may be required to:
- register for VAT locally,
- apply different VAT treatment to supplies,
- and comply with additional local reporting obligations.
Importantly, a Fixed Establishment analysis does not itself determine whether the arrangement constitutes a supply of goods or services. Rather, it impacts the place of supply and the VAT obligations arising from the arrangement.
Conclusion
Contract and toll manufacturing are not merely commercial structures; they are VAT sensitive classifications with potentially significant compliance consequences.
Given that the EU VAT Directive does not formally define either model, VAT authorities rely heavily on economic reality, CJEU case law, and national tests to determine the true nature of the supply.
Companies that rely solely on contractual models or assume that ownership of materials is decisive expose themselves to unnecessary VAT risks.
The safest approach is to ensure that contracts and economic reality are aligned to ensure correct VAT treatment.
If you would like assistance with your supply chains in order to determine the nature of the supply, please feel free to reach out to us and one of our experienced consultants will be happy to assist you.